If you pass away leaving a substantial estate, a significant portion of your property may pass to the government in the form of estate taxes, rather than to the beneficiaries, of your choosing. However, it is often possible to reduce or even eliminate estate taxes with proper planning. While it is almost never too late, early planning is generally the key to maximizing the benefits of certain estate planning techniques. For example, where an asset is removed from your state today, all appreciation occurring between now and the date of your passing will also be removed from your taxable estate.

The techniques discussed below are not appropriate for every estate plan. Indeed, if you anticipate that your assets will not be subject to estate taxes upon your passing, it may not be necessary to employ these techniques in order to maximize the amount that ultimately passes to your beneficiaries. For this reason, we will carefully analyze your particular circumstances and explore the specific techniques that are right for you. Indeed, we pride ourselves on tailoring each estate plan to the unique needs of each individual client.

Please be aware that the advanced planning techniques discussed below are usually implemented only after a basic estate plan has been created. Typically, a basis estate plan will include a living trust, a pour over will, an advanced healthcare directive, and a power of attorney. This basic estate plan will provide the foundation upon which an advanced estate plan is built. While proper planning takes time and energy, the benefits can be substantial. Discussed below are several techniques that you may wish to consider: Grantor Retained Annuity Trusts, and Intentionally Defective Grantor Trusts. Additional techniques, such as irrevocable life insurance trusts, certain specially structured charitable donations, and qualified personal residence trusts, are discussed in other articles on the website.

GRANTOR RETAINED ANNUITY TRUSTS

A Grantor Retained Annuity Trust (GRAT) allows a donor to transfer property to a trust, retaining for a period of time the right to receive an income stream (an annuity) from the property. After all of the required annuity payments have been made to the grantor, the assets remaining in the trust (referred to as the remainder) pass to the beneficiaries chosen by the grantor when the trust was created. The benefit of this technique is that, although the entire property goes to the donor’s beneficiaries at the end of the term, the gift tax on the transfer is computed on the remainder interest at the time of the gift. This can permit a transfer of property at a fraction of its actual value.

The transfer of the assets to a GRAT is potentially subject to gift of taxes. The advantage of using a GRAT, however, is that the value of the gift is discounted for the income interest retained by the grantor. In other words, the fair market value of the gift is not the entire value of the assets transferred because the grantor is retaining an income interest for a period of time. Rather, the gift is only the value of the remainder interest. The gift tax is calculated on this remainder interest. If a taxpayer’s gift tax credit has not been completely used, there may be no gift tax to be paid. Moreover, in certain instances, it may be possible to reduce the value of the gift to almost nothing, and therefore minimize any erosion of the grantor’s gift tax credit. This is true because, in apportioning the value of the respective interests in the GRAT, the government uses an assumed rate of return called the applicable federal rate (AFR). The amount by which the assets held by the GRAT exceed this assumed rate of return in not subjected to gift tax.

For example, suppose that the grantor creates a GRAT with stock valued at $1,000,000. If the GRAT is obligated to pay the grantor $230,900 per year for five years, and the AFR (the government’s assumed rate of return) is five percent, the value of the interest transferred to the remainder beneficiaries for gift tax purposes will be $318.45. In other words, using its assumed rate of return, the government is willing to bet that almost nothing will be left for the remainder beneficiaries after all the required payments are made to the grantor. Under this scenario, the taxpayer can only win the bet.

If the assets remaining in the GRAT have increased to $5,000,000 at the end of the five year annuity period, assets with a value of $5,000,000 will have been transferred to the remainder beneficiaries for a gift tax value of only $318.45. In other words, the gift will have been made with almost no exposure to gift taxes. On the other hand, if the assets perform at a rate that is less than the AFR, the taxpayer has lost nothing except for the cost of creating the GRAT. For example, if the stock held by the GRAT were to decline in value, such that the remainder beneficiaries receive nothing (I.E. the government wins the bet), the grantor has potentially been exposed to gift taxes upon a gift of only $318.45. In other words, the donor will have almost no gift tax exposure. This technique is commonly referred to as a “zero GRAT” because the assumed value transferred to the remainder beneficiaries is almost zero.

It should be noted that a GRAT will generally only be appropriate where it is anticipated that an asset will appreciate at a rate significantly greater than the government’s assumed growth rate (the AFR). Indeed, in some cases, the donor may be able to achieve a better result with outright gifting. For example, if a 55 year old grantor transfers $5,000,000 to a five year GRAT with an annuity payment of $1,167,679 when the AFR is 5.4% the relevant calculations reveal that a taxable gift has been made in the amount of $102,406. If the assets actually grow at a rate that is substantially lower than the AFR, nothing will be left for the beneficiary at the end of the five year GRAT term. Moreover, the grantor will have paid gift taxes on the transfer of $102,406, as well as having paid the expenses associated with the creation and operation of the GRAT. By contrast, if the grantor had made an outright gift of $102,406, the beneficiary could have invested the money, and ultimately would stand to receive an amount greater than a GRAT would produce.

While a “zero GRAT” is one method of avoiding this problem, this technique may not be appropriate for the circumstances of a particular case. Moreover, significant restrictions limit the amount by which the annuity payments under a GRAT can vary from year to year. For example, it is not permissible for a GRAT to pay $ 10,000 in one year and $100,000 in the next year. By contrast, other techniques may permit greater flexibility in the structuring of annuity payments.

The use of a GRAT can have significant benefits in the appropriate circumstances. In particular, a GRAT may be appropriate where it is anticipated that assets will significantly appreciate in the immediate future. However, the key to gaining the most leverage from this technique is early planning, such that appreciation will occur outside of the grantor’s taxable estate. It would be our pleasure to analyze your circumstances to determine whether early planning with a GRAT would be right for you.

INTENTIONALLY DEFECTIVE GRANTOR TRUSTS

The intentionally defective grantor trust (IDGT) is commonly used as an estate freezing device. In other words, an IDGT “locks in” the value of an asset for transfer tax purposes, and all future appreciation in the transferred assets is shifted to the donor’s beneficiaries. A transfer to a properly structured IDGT is considered a completed transfer for estate and gift tax purposes, but incomplete for income tax purposes. Therefore, an IDGT will not be included in the donor’s estate upon his or her death, even though the donor is obligated to pay the income taxes generated by the trust while alive. By paying the income taxes attributable to the trust assets, the donor is essentially making additional gifts to the trust beneficiaries that are not subject to gift tax.

Preliminarily, it should be noted that the use of the word “defective” is somewhat a misnomer. This is a reference to a violation of certain rules that would otherwise make the transfer effective for income tax purposes. However, in this context, the taxpayer is intentionally violating these rules. As a result, the trust is not “defective” in the sense that it is improperly drafted, but rather is only “defective” in the sense that it does not meet the requirements necessary to prevent the income of the trust from being attributed to the donor (which, of course, is entirely the point of an IDGT).

In any event, an IDGT generally is structured as a sale of certain assets from the donor to the IDGT. The IRS generally will respect a properly structured IDGT as a sale; however, the transaction may be deemed a taxable gift if improperly structured. For this reason, attention to detail is necessary relative to the formalities associated with the transaction.

For example, before selling assets to the IDGT, the grantor should initially contribute property having a value equal to approximately ten to twenty percent of the fair market value of the assets to be sold (depending upon the circumstances). The purpose of contributing “seed money” is to avoid having the sold assets constitute the sole source of payment for the note, such that the IRS could argue that the transaction was without substance. (If the sold assets are the source of payment, it might also be argued that the transaction is a transfer with a retained interest, which would cause the assets to be included in the grantor’s estate.) Following the contribution of seed money, the grantor then sells the assets to the IDG T in exchange for an interest bearing installment note. The installment note should be for a term of years and may be payable in installments with a balloon payment, or alternatively, an interest only note with a balloon payment on the due date.

As noted above, the IDGT technique freezes the value of the note in the grantor’s estate. In other words, any increase in value of the assets sold will not be taxed in the grantor’s estate, but rather will inure to the benefit of the trust beneficiaries. When the grantor dies, only the fair market value of the note is included in the grantor’s estate. That value generally will be less than the outstanding principal of the note. This is true because a buyer in the open market generally would not pay the full face value of the note in order to purchase it. The precise value of the note may depend upon several factors, including the payout of the note, the interest rate, the absence of security, default provisions, and other note terms.

There are no income tax consequences on the sale of the asset to the trust because the grantor is treated as the owner of the trust for income tax purposes. As a result, the grantor will not be required to pay capital gains tax by reason of the sale to the IDGT. Although the grantor is taxed on income generated by the trust (income the grantor does not receive), the grantor is further reducing their estate by the amount of the income tax paid.

By contrast, if an outright gift had been made to the beneficiaries, the beneficiaries, rather than the grantor, would be required to pay the income taxes associated with the assets. In other words the payment of tax by the grantor on the trust income is essentially a tax-free gift to the beneficiaries. Parenthetically, it should be noted that it is acceptable for the trust to provide the trustee with discretion to make distributions to the grantor sufficient to pay the income tax obligations generated by the trust, but that payment to the grantor can not be mandatory.

The following is an illustration of the manner in which an IDGT may be structured. The grantor starts by creating a defective grantor trust (in other words, a trust that is the effective for gift and estate tax purposes, but ineffective for income tax purposes). A number of methods can be used to achieve this result, such as providing some person other than the grantor or beneficiaries the power to name additional beneficiaries.

After creating the trust, the grantor donates “seed money” to fund the trust. Suppose that the asset to be sold to the IDGT is closely held stock with a value of 1,000,000. If the circumstances of the case required “seed money” of twenty percent, the donor would transfer $200,000 in cash to the IDGT (in other words, twenty percent of $1,000,000). Because this is a completed transfer for gift and estate tax purposes, the donor would be required to file a gift tax return (and perhaps pay gift tax) based upon this $200,000 gift.

The donor and the trustee then enter into an agreement for the IDGT to purchase the stock from the grantor in exchange for an interest only note with a balloon payment of $1,000,000 after five years. While the donor will receive interest payments, because the trust is treated as the property of the grantor for income tax purposes, the grantor is not required to pay income taxes as the result of these payments. In other words, the IRS treats the transaction as if the grantor is paying himself interest, and consequently no income taxes are due.

At the end of the five year term of the note, the grantor receives the balloon payment of 1,000,000 from the IDGT. If the stock has increased in value to$5,000,000, the beneficiaries have received a $5,000,000 asset at a transfer tax cost of $200,000 (the amount of the “seed money”). In the event that the grantor passes away during the term of the note, the unpaid principal is included in the grantor’s estate. Suppose that the grantor in this example passes away in the fourth year of the term of the note. Because no payments have been made to reduce the principal of the note, the full $1,000,000 note amount would be included in the grantor’s taxable estate. If the stock has increased in value to $4,000,000 as of the grantor’s passing, the grantor has passed $4,200,000 (4,000,000 in stock plus the 200,000 “seed money”) to the beneficiaries at a transfer tax cost of 1,200,000 (the $1,000,000 principal balance of the note plus the $200,000 “seed money”).

If the grantor owns $2,000,000 in assets other than the note in year four, the grantor’s total estate would effectively be $3,200,000 using the IDGT method (the $1,200,000 transfer tax cost of the IDGT plus the $2,000,000 of other assets). By contrast, if the grantor had not created the IDGT, the grantor’s estate would be $6,000,000 ($4,000,000 of stock plus $2,000,000 of other assets). In other words, the grantor will have effectively reduced his taxable estate by $2,800,000 by using an IDGT. Assuming that the grantor passes away in the year 2009, this would eliminate the estate tax obligation at approximately $1,150,000 In other words, approximately $1,150,000 more will pass to the grantor’s chosen beneficiaries, rather than the government.

One advantage of an IDGT over a GRAT is that an IDGT provides greater flexibility in structuring payments to the grantor. With a GRAT, significant restrictions limit the amount by which the annuity payments can vary from year to year. By contrast, the note in an IDGT is not subject to these restrictions. Indeed, the note can provide for the payment of interest only, with a balloon payment at the end of the term of the note. When this approach is used, the principal may remain in the IDGT so that income can compound for the benefit of the beneficiaries, rather than being returned to the grantor.

Another benefit of an IDGT is the flexibility in drafting the Trust. The client can structure the Trust to act as a spendthrift trust for the Trust beneficiaries. This can protect the assets of the trust from the claims of unsecured creditors. The Trust may also be structured as a generation skipping trust, which will allow the assets to pass to future generations free of estate taxes.

A significant drawback of using an IDGT is that there is not a single source of authority delineating the acceptable boundaries relative to the IDGT technique. Generally speaking, the IDGT is the product of a patchwork of case law, abstract reasoning, and indirect authority. By contrast, the IRS has provided clear guidelines (and even sample documents) for other techniques. As a result, the IDGT is an effective estate planning tool only where the value of the donated assets increase in value. Consequently, an IDGT is not appropriate for every case.

As is the case with a GRAT, early planning is the key to getting the most out of using an IDGT. A number of factors, some of which are beyond the scope of the above discussion, may militate either in favor or against the use of an IDGT in your estate plan. Consequently, it will be necessary to carefully analyze your unique circumstances to determine whether an IDGT is right for you.

CONCLUSION

With proper planning, it is possible to ensure that your chosen beneficiaries receive your property, rather than the government. While the techniques discussed above require intricate analysis and detailed planning, the benefits achieved are often substantial.